Half Now Completely Written Platonic Dialogue on What the Federal Reserve Is Doing--or Not Doing--Right Now…
Glaukon: The core price level is now 4% lower than people back at the start of 2008 expected it to be now.
Glaukon: Back before 2008 people expected inflation to be about 2.5%/year over the long run. Now they expect 2%/year. That means that right now the expected price level as of 2022 is 0.5%/year x 10 years + 4% = 9% below what people back at the start of 2008 expected then that the 2022 price level would be right now.
Klio: And nominal GDP right now is 11% below what people back at the start of 2008 expected then that it would be right now. I presume you have a point?
Glaukon: It is simple. I presume that we are all agreed that the most important task of a central bank is to provide a stable macroeconomic environment within which people can plan--to not disappoint expectations?
Kassandra: I will give you that assumption, and see where you take it…
Glaukon: And I presume that we are all agreed that that means that stabilizing the growth trajectories of the overall price level and the overall spending rate--rather than stabilizing the price of gold or the level of nominal interest rates or the stock of liquid assets used as means of payment or the size of the Federal Reserve balance sheet--is the principal task of a central bank?
Klio: Now comes the hammer…
Glaukon: Why aren't Ben Bernanke and company moving heaven and earth to return both the the overall price level and total spending to their pre-2008 anticipated growth trajectories? They are not stupid people. Yet it seems obvious to me--to us--that they should be doing so. And they are not. Why is it not obvious to them?
Daedalos: I would start by dividing the potential voting members of the Federal Open Market Committee into several groups. The first group is made up of Elizabeth Duke, Jerome Powell, and Esther George. The second group is made up of Dan Tarullo, Sarah Bloom Raskin, Sandra Pianalto, and Dennis Lockhart. The third group is made up of Eric Rosengren, Charles Evans, and John Williams. The fourth group is made up of Jeffrey Lacker, Charles Plosser, James Bullard, Narayana Kocherlakota, and Richard Fisher. And the fifth group is made up of Ben Bernanke, Janet Yellen, Jeremy Stein, and William Dudley.
The first group are financial-sector worthies with a bias toward inaction and not rocking boats, but willing to go along with strong views from elsewhere on the committee. The second group are those without strong monetary policy opinions of their own who are distressed by the current situation and willing to engage in boat-rocking if they can be convinced it would be constructive.
The third group--Rosengren, Evans, and Williams--think like we do.
The fourth group--it is not at all clear to me right now that the fourth group "think" at all. They have been wrong about the state of the economy and the balance of risks since 2008. They know that they were wrong. Yet all that they can think of to do right now is to cling tight to their previous policy positions and hope that events take a turn that makes them look less foolish in the future than they look now. If they admit that they have been wrong--if they mark their beliefs to market--then, they think, they lose authority, influence, and face. They are like bankrupt Savings and Loans refusing to recognize their situation and gambling for resurrection. I heard both Richard Fisher and Narayana Kocherlakota several months ago, and faced with probing questions he would not stoop to engage…
Kurush: OK. I get it. The fifth group?
Daedalos: The fifth group--Bernanke, Yellen, Stein, and Dudley--are, or ought to be, the deciders here. They have deep knowledge of and strong substantive views about monetary policy. They are not reputationally bankrupt and thus gambling for reputational resurrection. They are the ones who ought to be adopting Jan Hatzius's proposals that the Fed buy $50 billion of long-term bonds a week until expectations of prices and of nominal spending return to their pre-2008 growth path. They are the ones who ought to be adopting Christina Romer's proposals for price-level targeting. They are the ones who ought to be adopting Olivier Blanchard's proposals for a long-run inflation target of 3+%/year rather than 2-%/year. They are the ones who ought to be adopting Joe Gagnon's proposals for--since the FHFA won't do its job and rebalance housing finance--the Federal Reserve to fund vehicles to deal with the underwater-borrower problems that beset our mortgage and housing markets and are holding back recovery.
Glaukon: It is obvious to all of us here that this Group V ought to be joining Group III in policy advocacy, sweeping up Groups I and II, and pushing some of these policies of bold experimentation through the FOMC. The downside risks are negligible. The upside potential for gain is enormous. And the current situation is dire.
So why is what is obvious to us not obvious to them?
Lykourgos: Logically, it must be because they suppose that the benefits to mass mortgage refinancing and higher long-run inflation targets and price-level targeting and open-ended commitments to asset purchases until policy goals are attained are smaller than we envision, and that the risks and costs of such policies are larger. Shall we start with the benefits?
Daedalos: Let me pick up that thread--and let me note that my setting forth these arguments is empathically not an endorsement of their correctness. In my view, the best place to go to understand what the Fed is thinking is not its own statements but rather the writings of John Berry. And John Berry says that the Federal Reserve has done three things:
- dropped their target for overnight interest rates to almost zero;
- put downward pressure on long-term interest rates by announcing that they do not intend to raise that target overnight interest rate until late 2014;
- put still more downward pressure on long-term interest rate by purchasing $2.3 trillion worth of longer-term Treasury and asset-backed securities for cash.
And Berry writes, in International Economy:
What is left for the Fed? Not much. The central bank could buy more assets, but that probably would have only a limited effect on markets because long-term rates are already at record lows…. [T]he conditional commitment to keep rates low for two more years could be extended to 2015 or 2016, but again, at the margin, how much would that help?…
If Berry's views are a good reflection of the internal thinking of FOMC Group V--and I believe that they are--Group V thinks that Federal Reserve policy affects the economy by either (a) lowering the safe overnight nominal interest rate, or (b) lowering the term premium; that both are now so low that additional attempts to lower them could not lower them by much; and that such small marginal additional lowerings would have only minuscule effects on the incentives facing businesses and financiers, and only minimal effects on the economy.
Glaukon: So that the Federal Reserve now thinks that it is out of ammunition?
Daedalos: That is the implication of Berry's position.
Glaukon: But Ben Bernanke says that that the Federal Reserve is not out of ammunition.
Daedalos: It is an implication of Berry's position that Bernanke is bluffing.
Glaukon: But it is not nominal interest rates that matter. It is real interest rates--the nominal interest rate minus expected inflation. And monetary ease affects both blades of the scissors: it reduces nominal interest rates and raises expected inflation. Even if you cannot lower nominal interest rates appreciably, the Fed can raise expected inflation--it does not have to be bluffing.
Klio: Indeed, Bernanke says that he could raise expected inflation but does not want to. Berry goes on to quote Bernanke from his April 2012 post-FOMC meeting press conference:
I guess the question is: does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased pace of reduction in the unemployment rate? The view of the committee is that that would be very reckless…. [The Federal Reserve has] spent thirty years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.
Daedalos: I don't understand that.
Kurush: Back when we worked in the Bentsen Treasury, the rule-of-thumb that Alan Greenspan set out in his private meetings with Bentsen was that a 1%-point reduction in the long-term real interest rate was about the equivalent of a 1%-point of GDP government purchases expansion--that you could expect a 2% boost to the economy in the short-run from such an interest rate movement.
Klio: Which means that if Bernanke could raise the expected price level in 2022 by 10%, that would boost real GDP next year by about 2%, and reduce unemployment by 1%-point. Isn't that worth doing?
Glaukon: I would think so.
Daedalos: So would I.
Lykourgos: Me as well.
Kurush: But it seems that Bernanke does not.
Kassandra: And while Bernanke may be willing to assume for purposes of argument that the Federal Reserve has policy tools that can raise expected inflation, it is far from clear to me that that is the case. A belief that the Federal Reserve by buying and selling a few assets can raise economy-wide expectations of inflation seems to me to be a close cousin of a belief that the federal government by raising taxes and cutting spending can restore business confidence.
Klio: Indeed, as Robert Waldmann says, it is another mode of faith in unseeable beings--but this time belief in the Expected Inflation Imp rather than the Confidence Fairy. If you are going to bet on unseeable beings, why not bet on the Confidence Fairy rather than the Expected Inflation Imp?
Glaukon: Especially because if the Confidence Fairy shows up everything is fine, while if the Expected Inflation Imp shows up then you have destabilized inflation expectations and have another, albeit different and far less serious, problem to deal with.
Lykourgos: But, but, but… Bernanke believes in the Inflation Expectations Imp! He really, really does! Bernanke:
It is true that current monetary conditions in Japan limit the effectiveness of standard open-market operations. However… liquidity trap or no, monetary policy retains considerable power to expand nominal aggregate demand…. Despite the apparent liquidity trap, monetary policymakers retain the power to increase nominal aggregate demand and the price level…. [O]ne can make what amounts to an arbitrage argument--the most convincing type of argument in an economic context…. Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence…
Kassandra: And in his 1999 Japan paper, he explicitly called for a target rate of inflation in the 3-4% range to be maintained for a number of years!
Glaukon: I know, I know. He preached, but he does not practice.
Kurush: I wonder if Tim Geithner thought he was getting Bernanke (1999) when he recommended to President Barack Obama that he renominate Ben Bernanke for another term as Federal Reserve Chair, or whether Geithner did not think the issue through any more than he thought the question of who should head the FHFA through…
Lykourgos: You know as well as I do that the author of this dialogue finds it very disturbing to think about the Enigma of Geithner--at least until November 7, 2012.
Kurush: I do?
Lykourgos: Yes. We are both equally figments of his imagination.
Kurush: But can't I be a figment that has a greater attachment to understanding and a lesser attachment to political effectiveness than you do?
Lykourgos: Right now we are thinking about the Enigma of Bernanke. Crawl before you walk. The Enigma of Bernanke is disturbing enough.
Klio: And if it turns out that Bernanke (1999) is wrong--if the Federal Reserve goes all-in on asset purchases, all the way up to Jan Hatzius's $5 trillion balance sheet--and if inflation expectations do not respond, then won't Bernanke have revealed that he is out of ammunition, and have lost his ability to bluff? There are two downsides to a policy of going all-in on asset purchases: the downside that it might work too well and leave us with the problem of a cut cable connecting the economy to its inflation-expectations anchor, and the downside that it might not work at all and reveal that the Federal Reserve would indeed be powerless to stop deflation.
Kassandra: Those two downsides might well make it a risk that Bernanke does want to run…
Glaukon: But Bernanke (1999) on Japan, Bernanke (1999) on Japan…
Kassandra: You have to realize that, from Bernanke's perspective, he has already gone all-in on expansionary monetary policy. Suppose you had told Bernanke at the end of 2008 when he pushed the big red button that he was going to (a) lower the federal funds rate to zero, (b) promise to keep it at zero for six years, and (c ) expand the Federal Reserve's balance-sheet to $3 trillion. Suppose you had then asked him: "What do you think that chances are that nominal GDP would still be running below its pre-2008 trend at the end of 2012?" He would have answered you that there was only one chance in a thousand that such monetary policies would prove insufficient to restore demand to or above its pre-2008 trend growth path.
Klio: And if pushing the Federal Reserve's balance sheet from $700 billion to $3 trillion does not do the job, what reason is there to be confident that pushing it from $3 trillion to $5 trillion would do the job?
Glaukon: But you don't have to be confident it would work for it to be worth trying…
Kassandra: But you do have to be confident it would work to risk revealing that you are actually out of ammunition and that your claims that you could stop deflation are a bluff--that you could not stop deflation if it were to take hold…
Daedalos: But we could stop deflation! Spending stops deflation! And the government's spending is as good as anybody's…
Kurush: And now we see the import of the conversations between CEA Chair Christina Romer and Federal Reserve Chair Ben Bernanke that Christy…
Glaukon: You think it was Christy?
Kurush: You think it was Ben?
Glaukon: Actually, I think both of them talked to their staffs, which are leak-resistant but not waterproof: gortex rather than latex.
Glaukon: You were saying?
Kurush: And now we see the import of the conversations between CEA Chair Christina Romer and Federal Reserve Chair Ben Bernanke that Michael Grunwald reports in his "The New New Deal":
The recovery stalled during Recovery Summer…. The main problem was a debt crisis in Greece…. [S]tates were slashing their budgets again, and Republicans were blocking Obama's push for more fiscal relief. And the Fed… was curiously passive…. At their monthly lunches, Christy Romer prodded Bernanke: "You need to do more monetary stimulus". But Bernanke didn't want to unless he absolutely had to. As he reminded Romer, there were other ways to jolt the economy: "You need to do more fiscal stimulus!"
From Bernanke's perspective, he is willing to do his share of a coordinated monetary-mortgage-fiscal policy to boost the economy back up to full employment. But he is not willing to take up the slack and do the full job if both mortgage policy and fiscal policy are missing in action.
Glaukon: But then why isn't he moving heaven and earth to get the Republicans in Congress to stop blocking more fiscal policy?
Kurush: From his perspective, he is--listen to him when he testifies. That the TV newscasters and the political reporters ignore the fact that Bernanke has spoken more harshly to his own party's members of Congress than any Federal Reserve Chair ever is not his fault, but rather theirs.
Daedalos: And a great deal of it is the Obama Administration's fault. In my view, one powerful current of thought inside the Federal Reserve staff is the "we did our part of the job, and then the White House and the Treasury let us down" current of thought. Recall what Joe Gagnon said:
[O]ne of the biggest goals of QEI was to push down the mortgage rate to spark a refinancing boom to encourage households and enable households to reduce their expenditures and repair their balance sheets and be able to spend again. That worked not quite as well as we hoped because the administration’s program for getting underwater borrowers to borrow didn’t work and I think that’s a true disaster that has no excuse. I have nothing but incredible, there’s just, the blame the administration on not doing this is just incredible. This could have been a huge success. We got the lowest 30-year mortgage rates in history and we couldn’t take advantage of them to the extent that we could. We got about a trillion dollars in refinancing when we should have gotten two or three trillion dollars in refinancing.
Klio: There is video here: http://vimeo.com/22972938
Kurush: So why no effective mortgage policy?
Lykourgos: We are getting close to the Enigma of Geithner again…
Daedalos: Remember that Bernanke is not just Bernanke of Bernanke on Japan (1999) and not just Bernanke the Federal Reserve Chair but also the Bernanke of the Bernanke-Gertler credit channel. There does come a point where the Bernanke of the Bernanke-Gertler credit channel will conclude that--unless and until the credit channel in housing is unblocked--additional monetary stimulus will either (a) do nothing, or (b) create quasi-Hayekian structural problems of maladjustment that then will require painful correction.
Kurush: And do remember that the Governor of Texas called for Bernanke's lynching--an extraordinary thing for a Texas Republican to do to a Carolina Republican.
Klio: And do remember a President who has not been interested in giving Bernanke an aggressive left wing on the Board of Governors to counteract Group IV--did anybody even ask Jeremy Stein or Sarah Bloom Raskin or Dan Tarullo what their views of monetary policy are?
Lykourgos: We are getting close to the Enigma of Geithner again…
Glaukon: So what do you think happens now?
Daedalos: A small new quantitative easing program announced at Jackson Hole. A ferocious and vociferous Republican denunciation of the Federal Reserve in response. An election.
Lykourgos: And after the election the cards are redealt.
Glaukon: How might they be redealt?
Daedalos: Well, if Romney wins, and if Hubbard gets the Treasury and Mankiw gets another turn at the CEA, Bernanke-Hubbard-Mankiw should be able to make very sound technocratic monetary-mortgage-fiscal policy.
Kassandra: Remind me again what impact Hubbard and Mankiw had on George W. Bush-era economic policy?
Glaukon: And if the Treasury Secretary is, say, Rand Paul? Or if Obama wins reelection?